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<!DOCTYPE html PUBLIC "-//W3C//DTD XHTML 1.0 Transitional//EN" "http://www.w3.org/TR/xhtml1/DTD/xhtml1-transitional.dtd"> <html xmlns="http://www.w3.org/1999/xhtml"> <head><script type="text/javascript" src="/_static/js/bundle-playback.js?v=HxkREWBo" charset="utf-8"></script> <script type="text/javascript" src="/_static/js/wombat.js?v=txqj7nKC" charset="utf-8"></script> <script>window.RufflePlayer=window.RufflePlayer||{};window.RufflePlayer.config={"autoplay":"on","unmuteOverlay":"hidden"};</script> <script type="text/javascript" src="/_static/js/ruffle/ruffle.js"></script> <script type="text/javascript"> __wm.init("https://web.archive.org/web"); __wm.wombat("http://ideas.berkeleylawblogs.org:80/2009/04/19/a-rescue-plan-for-rating-agencies/","20090615005411","https://web.archive.org/","web","/_static/", "1245027251"); </script> <link rel="stylesheet" type="text/css" href="/_static/css/banner-styles.css?v=S1zqJCYt" /> <link rel="stylesheet" type="text/css" href="/_static/css/iconochive.css?v=3PDvdIFv" />  <meta http-equiv="Content-Type" content="text/html; charset=UTF-8"/> <title>Blue Sky: New Ideas for the Obama Administration — A Rescue Plan for Rating Agencies </title> <meta name="keywords" content="Obama, UC Berkeley, Ideas, Priorities, Berkeley Law"/> <meta name="description" content="Priorities and ideas for the Obama Administration by UC Berkeley professors and scholars."/> <meta name="robots" content="all"/> <link rel="stylesheet" href="https://web.archive.org/web/20090615005411cs_/http://ideas.berkeleylawblogs.org/wp-content/themes/Ideas/style.css" type="text/css" media="screen"/> <link rel="stylesheet" href="https://web.archive.org/web/20090615005411cs_/http://ideas.berkeleylawblogs.org/wp-content/themes/Ideas/centers.css" type="text/css"/> <link rel="alternate" type="application/rss+xml" title="Blue Sky: New Ideas for the Obama Administration RSS Feed" href="https://web.archive.org/web/20090615005411/http://ideas.berkeleylawblogs.org/feed/"/> <script type="text/javascript" src="https://web.archive.org/web/20090615005411js_/http://www-prod.law.berkeley.edu/files/jquery-1.2.6.min.js"></script> <script type="text/javascript" src="https://web.archive.org/web/20090615005411js_/http://www-prod.law.berkeley.edu/law.js"></script>  <style type="text/css"> /* temporary */ #header h1 { bottom:20px; } </style> </head> <body class="centers"> <div id="dropshadow_sides"> <div id="container"> <a href="#content" class="skiplink">Skip to content</a> <div id="header"> <h1><a href="https://web.archive.org/web/20090615005411/http://www.law.berkeley.edu/"><img src="https://web.archive.org/web/20090615005411im_/http://www-prod.law.berkeley.edu/img/berkeleylaw_only_small.png" alt="Berkeley Law" width="204" height="50"/></a></h1> </div> <ul id="navigation" class="navigation_mini"> </ul>  <div id="content"> <a href="https://web.archive.org/web/20090615005411/http://ideas.berkeleylawblogs.org/"><img src="https://web.archive.org/web/20090615005411im_/http://ideas.berkeleylawblogs.org/wp-content/themes/Ideas/images/priorities-logo.gif"></a>  <h2 class="nosifr"></h2>  <div class="middle"> <br> <div class="post" id="post-46"> <h3><a href="https://web.archive.org/web/20090615005411/http://ideas.berkeleylawblogs.org/2009/04/19/a-rescue-plan-for-rating-agencies/" rel="bookmark" title="Permanent Link: A Rescue Plan for Rating Agencies">A Rescue Plan for Rating Agencies</a></h3>  <div> <p>Vincent Fabié</p> <p>Revamp the business model of credit rating services: We must interpose an independent third-party between issuers and rating agencies to overcome inertia in rating agencies reform — before free-marketers take advantage of the current crisis to promote deregulation approaches.</p> <p>Everyone knows that we are in the midst of the worst credit crisis since the early 1930s. But what the casual observer may not know is that the system set up to protect investors is flawed to the core. The current crisis was driven, in part, by erroneously positive ratings of bonds backed by subprime residential mortgages. At the heart of the problem is the role of rating agencies and rating-driven regulations. These regulations determine how much capital certain institutions (e.g., insurance companies, banks) need to have available in order to own financial instruments. The safer the investment (i.e., the lower the probability of default), the less capital is required. Consequently, how an investment is rated determines how much capital a regulated institution such as a bank needs on hand. Thus, rating agencies have a profound influence on institutional investments – so profound that the rating agencies are the de facto allocators of capital in our system.</p> <p>Policy-makers continue to appeal for a critical review of rating services, and some commentators now advocate removing rating-driven regulations entirely. They consider that the problem in the recent crisis was not the wrong ratings in itself but the fact that these ratings were incorporated into law through rating-driven regulations. In this conception, regulators should not have relied on ratings agencies to assess the risk of bond holdings but on markets that would be a better judge of risk and value than any analyst or company.<span id="more-46"></span>This deregulatory approach radically underestimates the benefits of widespread credit ratings. Ideally, credit ratings provide independent, practical assessments of relative credit risk; improve the overall efficiency of the market; reduce costs for borrowers and lenders; and increase the lending market so that smaller actors can obtain financing. Considering these advantages, most market operators (i.e., market authorities, investors, rating agencies, banks) and observers still support the idea of regulations that incorporate independent ratings. However, they have recently expressed major concerns regarding the business model of rating agencies where issuers or arrangers pay for their own ratings, which creates an obvious incentive for a rating agency to award the rating that the issuer or arranger wants.</p> <p>In the early days of the rating business, beginning in the 1920s, a different “instinctive” market structure was in place: the person seeking an assessment of how risky an investment was – the investor him or herself – paid for it. However, in the early ‘70s, due to the development of photocopying which threatened the investor-pays model, and the widespread and increasing demand for publicly available ratings, in particular following the unforeseen default of Penn Central railway company, Moody’s and Standard & Poors began to charge the issuers – rather than the investors – for their ratings.</p> <p>To restore confidence in the wake of the subprime mess, I propose a new “investor-centric” rating framework that should address some of the most serious problems in the present system. In the schema I propose here, an independent third-party would represent the market (e.g., representative board of investors or a public authority) and interpose itself between the issuer and the rating agency to manage conflict of interest, achieve the transparency of rating methodologies, and guarantee the public availability of ratings.</p> <p>We should note in this context that market authorities in the E.U. and the U.S. (e.g., the S.E.C.) are already moving in this direction; they are involved in the initial steps of a public offering of securities through the mechanism of regulated disclosures as well as the granting of exemptions based on the size of the issue or the sophistication of investors.</p> <p>The proposed structure would therefore require the rating agencies to be selected and instructed by the relevant market authority. Issuers would continue to pay for ratings, but appointment and payment to all rating agencies for rating works would be passed through the market authority. This business structure would eliminate the risk of “rating shopping” and put an end to the widespread practice of direct negotiations between the issuer and the rating agency.</p> <p>This interposition of the market authority would also be in line with two major concerns expressed by both regulators and rating agencies which make clear that none of the contemplated reforms should (i) impede the flexibility and autonomy of rating agencies’ methodologies and confer on regulatory authorities the right or obligation to influence the content of ratings, for which the rating agencies should retain full responsibility, and (ii) not prevent the enactment of unified global regulations, as credit opinions know no borders.</p> <p>Finally, this business model would facilitate the implementation of incentivisation policies that would take into account the performance of a given rating agency in its remuneration scheme. In this respect, as suggested by Berkeley Research Fellow John P. Hunt, remuneration of rating agencies for new complex products could be improved by requiring an agency to disgorge profits on ratings that are later revealed to be of low quality.</p> <p>A summary chart of the proposal as compared with the current framework, may be presented as follows (click image to enlarge):</p> <p><a href="https://web.archive.org/web/20090615005411/http://ideas.berkeleylawblogs.org/files/2009/04/image001.png" title="image001.png"><img src="https://web.archive.org/web/20090615005411im_/http://ideas.berkeleylawblogs.org/files/2009/04/image001.png" alt="image001.png" width="528" height="334"/></a> <strong><em><br/> Click image to enlarge </em></strong></p> <p>In brief, it is still essential that rating agencies consistently provide investors with ratings, but crucial that these ratings be independent, objective and of the highest possible quality. As these agencies play a vital role in global securities and banking markets, regulatory authorities should not push, once again, for a much-reformed status quo that would lead to increase skepticism and favor deregulation approaches.<br/> This contribution is an extract from an essay to be released in May 2009</p> <p><em>Vincent Fabié is a Berkeley Visiting Scholar and Avocat à la Cour d’Appel de Paris - Herbert Smith Paris.</em></p> <p><em>All view expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to Herbert Smith LLP.</em></p> <p> <p class="post_footer"> </p> Both comments and pings are currently closed. </span></p> </p> </div> <br> <br> </div> <a name="respond"></a>   <p class="nocomments">Comments are closed.</p> <div class="alignleft">« <a href="https://web.archive.org/web/20090615005411/http://ideas.berkeleylawblogs.org/2009/03/08/too-much-salt-try-cap-and-trade-in-the-diet/">Too Much Salt? Try Cap and Trade in the Diet.</a></div> <div class="alignright"><a href="https://web.archive.org/web/20090615005411/http://ideas.berkeleylawblogs.org/2009/04/20/secret-torture-and-hidden-bonuses-giving-the-devil-his-due/">Secret torture and hidden bonuses: giving the devil his due</a> »</div> </div>  </div>   <div id="sidebar"> <h3><a href="https://web.archive.org/web/20090615005411/http://ideas.berkeleylawblogs.org/">Blue Sky: New Ideas for the Obama Administration</a></h3> <div class="sidebox">  <ul> <li id="text-2" class="widget widget_text"> <div class="textwidget"><form id="searchform" method="get" action="https://web.archive.org/web/20090615005411/http://ideas.berkeleylawblogs.org/"> <div> <input type="text" name="s" id="s" size="15"/><br/> <input type="submit" value="Search"/> </div> </form> <br/> </div> </li> <li id="categories-1" class="widget widget_categories"><h4 class="widgettitle">Topics</h4> <ul> <li class="cat-item cat-item-157"><a 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